Fair Value in Accounting: From Theory to Practice

By Shlomi Shuv and Yevgeni Ostrovsky

Fair Value Accounting: From Theory to Practice is a comprehensive guide to fair value measurement – one of the foundations of modern-day accounting. Fair value measurement is extremely important since it touches upon both accounting and finance. Many items in the financial statements are measured at fair value, e.g. financial instruments, items acquired in business combinations and, under IFRS, investment property. In addition, fair value is used extensively as a valuation base by corporate finance and valuation specialists. The book gradually unfolds the full theoretical framework for measuring fair value for accounting purposes, while providing clear, hands-on implementation guidelines. It includes concise and informative explanations, focusing on the theoretical and practical issues arising from the relevant accounting standards and using illustrative examples and further analysis.

• Language: English
• Publisher: Anthem Press
• Release date: May 17, 2022
• ISBN: 9781839984211

Book preview

Fair Value in Accounting

Fair Value in Accounting

From Theory to Practice

The Complete Handbook for Fair Value Measurement (IFRS & US GAAP)

Shlomi Shuv

Yevgeni Ostrovsky

Anthem Press

An imprint of Wimbledon Publishing Company

www.anthempress.com

This edition first published in UK and USA 2022

by ANTHEM PRESS

75–76 Blackfriars Road, London SE1 8HA, UK

or PO Box 9779, London SW19 7ZG, UK

and

244 Madison Ave #116, New York, NY 10016, USA

Copyright © Shlomi Shuv and Yevgeni Ostrovsky 2022

The author asserts the moral right to be identified as the author of this work.

All rights reserved. Without limiting the rights under copyright reserved above,

no part of this publication may be reproduced, stored or introduced into

a retrieval system, or transmitted, in any form or by any means

(electronic, mechanical, photocopying, recording or otherwise),

without the prior written permission of both the copyright

owner and the above publisher of this book.

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data

Names: Shuv, Shlomi, author. | Ostrovsky, Yevgeni, author.

Title: Fair value in accounting : from theory to practice /

Shlomi Shuv, Yevgeni Ostrovsky.

Description: New York, NY : Anthem Press, 2022. |

Includes bibliographical references. |

Identifiers: LCCN 2022000090 | ISBN 9781839984198 (hardback) |

ISBN 9781839984204 (pdf) | ISBN 9781839984211 (epub)

Subjects: LCSH: Fair value–Accounting.

Classification: LCC HF5681. V3 S48 2022 | DDC 657/.7–dc23/eng/20220107

LC record available at https://lccn.loc.gov/2022000090

ISBN-13: 978-1-83998-419-8 (Hbk)

ISBN-10: 1-83998-419-8 (Hbk)

Cover image: Double exposure of the city, graph, display of stocks and money for finance and business concept. By Number1411/Shutterstock.com

This title is also available as an e-book.

Disclaimer: The information contained in this book is not intended to address the circumstances of any particular entity. It does not constitute advice and should not be substituted for professional services, when such services are required.

Contents

Preface

Chapter 1Background

1. Overview

2. Use of Fair Value in IFRSs Compared to US GAAP

3. Key Principles

4. Differences between IFRS 13 and ASC Topic 820

Chapter 2Definition and Scope of Fair Value

1. Definition of Fair Value and the Fair Value Measurement Approach

2. Items within the Scope of the Standards

2.1. Overview

2.2. Exceptions to the measurement and disclosure requirements of IFRS 13

2.3. Exemptions applicable only to the disclosure requirements of IFRS 13

2.4. Exceptions to the measurement and disclosure requirements of ASC 820

Chapter 3Identifying the Asset or Liability to Be Measured

1. Overview

2. Characteristics of an Asset or Liability versus Characteristics of the Entity Holding the Asset

3. The Unit of Account of the Asset or Liability

Chapter 4Determining the Market in Which the Transaction Will Take Place

Chapter 5Identifying Market Participants

Chapter 6Defining the Transaction Price

1. Exit Price

2. Transaction Costs

3. Transfer Tax and Other Transaction Costs Relating to Investment Property (IFRS Only)

4. Transport Costs

Chapter 7Definition of an Orderly Transaction

1. Guiding Principle

2. Identifying Transactions That Are Not Orderly

3. Measuring Fair Value When the Volume or Level of Trading Activity for an Asset or a Liability Has Significantly Decreased

Chapter 8Fair Value at Initial Recognition

1. Does the Transaction Price Represent the Fair Value?

2. The Manner of Recognizing the Difference between Fair Value and Cost at Initial Recognition

Chapter 9Application to Nonfinancial Assets

1. Overview

2. The Highest and Best Use Premise

2.1. Guiding principle

2.2. Defensive use of nonfinancial assets

3. Valuation Premise for Nonfinancial Assets

3.1. Guiding principle

3.2. A nonfinancial asset’s highest and best use is in combination with other assets and/or liabilities

3.3. A Nonfinancial asset’s highest and best use is on a standalone basis

3.4. Valuation premise versus unit of account

Chapter 10Measuring Fair Value of Liabilities and Equity Instruments

1. Guiding Principle

2. Transfer versus Settlement

3. Liabilities and Equity Instruments Held by Other Parties as Assets

3.1. Measurement hierarchy

3.2. Adjustments to the quoted price of the corresponding asset

3.3. Restrictions placed on the transfer of the corresponding asset

4. The Measured Item Is Not Held by Other Parties as Assets

5. Non-Performance Risk

5.1. Overview

5.2. The underlying assumption—the non-performance risk is identical before and after the transfer

5.3. Practical considerations in adjusting fair value in respect of a reporting entity’s own non-performance risk

6. Restriction on the Transfer of a Liability or Equity Instrument

7. Financial Liability with a Demand Feature (IFRS Only)

7.1. Overview

7.2. Potential exceptions in connection with the minimal fair value restriction under IFRS

Chapter 11Application to Financial Instruments with Netting Positions

1. Overview

2. Relevant Definitions

3. Scope of the Exception

4. Qualifying Offsetting in Respect of Market Risk Exposure

5. Qualifying Offsetting in Respect of the Credit Risk of the Reporting Entity and the Counterparty

6. The Relationship between the Measurement of the Fair Value of a Net Position and Its Presentation in the Statement of Financial Position

7. Allocation of the Portfolio-Level Adjustments to Individual Instruments

Chapter 12Valuation Techniques

1. Overview

2. Considerations in Selecting a Valuation Technique

2.1. Guiding principle

2.2. The quoted price restriction when there is an active market for an identical asset or liability

3. Principal Approaches of Valuation Techniques

3.1. Overview

3.2. The market approach

3.3. The cost approach

3.4. The income approach

4. Using Multiple Valuation Techniques

5. Calibration of Valuation Techniques

6. Changing the Valuation Techniques

7. Adjusting Inputs Used in the Valuation or Adjusting the Valuation Techniques Themselves

7.1. Overview

7.2. The connection between making adjustments and the unit of account

8. Selecting the Inputs Used in the Valuation Technique and the Fair Value Hierarchy

8.1. Overview

8.2. Observable versus unobservable inputs

8.3. Inputs based on bid and ask prices

8.4. The fair value hierarchy

8.5. Level 1 inputs

8.6. Level 2 inputs

8.7. Level 3 inputs

Chapter 13Disclosure Provisions

1. Overview

2. The Scope of the Disclosure Requirements

3. The Objective of the Disclosure

4. Recurring and Nonrecurring Fair Value Measurements

5. Determining Appropriate Classes of Assets and Liabilities

6. Summary of Disclosure Requirements

7. Disclosure Requirements for Assets and Liabilities Measured at Fair Value

8. The Meaning of the Term End of the Reporting Period

9. Policy Regarding Transfers between Levels within the Fair Value Hierarchy

10. Disclosure Provisions That Apply to Fair Value Used Only for the Notes to the Financial Statements

11. Other Required Disclosures

12. Disclosure Examples

12.1. Example of disclosure regarding fair value hierarchy categorization

12.2. Example of disclosure in respect of reconciliation from opening to closing balances

12.3. Example for disclosure about valuation techniques and quantitative data used

13. Disclosures for Investments Subject to the NAV Practical Expedient (US GAAP Only)

Preface

Fair value, currently a very significant measurement base in financial statements, and a commonly used term in itself, is, somewhat surprisingly, a relatively new term in the world of accounting. Just to illustrate, the Framework for the Preparation and Presentation of Financial Statements, originally published in 1989 by the International Accounting Standards Board (IASB), makes no reference whatsoever to this term. This is despite the fact that measurement bases having similar or overlapping principles, such as present value or realizable value, are, indeed, mentioned.

The term fair value was first mentioned in US Generally Accepted Principles (US GAAP) in Statement of Financial Accounting Concepts No. 7 regarding Using Cash Flow Information and Present Value in Accounting Measurements, published by the Financial Accounting Standards Board (FASB) in 2000, although parts of the definition itself but not the term fair value were already used in Statement of Financial Accounting Concepts No. 6 regarding Elements of Financial Statements, originally published in 1985.

Over the years, fair value has been used increasingly by the world’s leading accounting standard-setting bodies, both for measurement and for disclosure purposes. Thus, for example, using fair value as a measurement base is currently widespread in measurement of financial instruments and business combinations, and under International Financial Reporting Standards (IFRSs), fair value is also employed to measure investment property. As fair value became an increasingly used measurement base, the need to formulate a uniform and consistent rationale for fair value measurement has arisen, along with the need to put in place comprehensive disclosure principles that will provide financial statements’ users with additional information, among other things, about the reliability of fair value estimates. This rationale was first reflected in US GAAP in Statement of Financial Accounting Standards No. 157—Fair Value Measurements (SFAS 157) and thereafter in the provisions of IFRS upon publication of IFRS 13—Fair Value Measurement, which, in effect, converged with the American standard.

This book aims to serve as a comprehensive guide to fair value measurement. In this book, we gradually unfold a comprehensive framework of fair value measurement from a detail-oriented and practical standpoint, both pursuant to IFRS 13 and Accounting Standards Codification (ASC) 820. This is done while referring to subtle nuances between the two accounting standard systems, including with regard to disclosure. In many cases, we opted to focus on theoretical and practical issues stemming from the Standards by providing further examples and analysis, referring to the Standards’ explanatory notes and to existing practices. The chapter dealing with disclosure provisions includes a full review of the disclosure provisions and relevant examples, as well as summaries in tabular format as to the nature of the required disclosure, and includes a comparison between the Standards’ disclosure provisions.

The first part of this book (Chapters 1 and 2) covers the definition of fair value as well as various scope issues. The second part (Chapters 3–8) discusses core principles in fair value measurement. The third part (Chapters 9–12) deals with issues of application to assets and liabilities and valuation techniques. Chapter 13 discusses in detail the related disclosure requirements.

The book is intended as an essential tool not only for professionals involved in preparing or auditing financial statements—such as accountants and financial managers—but also for practitioners in related domains, such as appraisers and preparers of valuations for legal proceedings based on fair value. We believe the book’s instructive and user-friendly structure and its many practical examples could also make it highly useful for students (specifically, accounting students as well as individuals preparing to take the CPA exams) as well as for other academic purposes.

The accounting definition of fair value focuses on the notional price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date. Over the years, this definition became a universal convention. Among other things, it entails the use of methods that had already been commonly used in finance and appraisal theories, since it focuses on market prices. Nevertheless, the actual application of fair value measurement is not always straightforward. Firstly, as is the case in most economic calculations, measurement of fair value may be subject to a fair amount of uncertainty and subjectivity. Secondly, in quite a few theoretical accounting issues, judgment exercised by the entity may lead to a dramatic change in the way the measured item is perceived, and this might result in a significantly different fair value measurement. These issues pertain, among other things, to questions such as distinguishing between the characteristics of the measured item and the characteristics of the reporting entity itself, the unit of account in the light of which the measurement is carried out, the ability or the necessity to select or change different measurement approaches as well as the measurement parameters used in those approaches, issues pertaining to unique or complementary assets, dealing with restrictions placed on the transfer of the measured asset or liability and more. In that context it is important to note that the difficulty in understanding fair value stems, among other things, from the fact that the definition does not necessarily focus on the reporting entity itself. Thus, for example, restrictions or advantages that would have surely been taken into account by investors in a specific reporting entity would not necessarily be reflected in the measurement of the fair value of the assets it holds. This may be relevant, for instance, for economies or diseconomies of scale, the reporting entity’s asset mix or number of assets and so forth.

The relevant Standards list three widely used valuation approaches: the market approach, the cost approach and the income approach, and they include a significant conceptual depth. It is, therefore, interesting to note that the role of accounting theories dealing with fair value may go beyond the classical boundaries of financial statements and permeate into related content worlds—such as economic opinions issued as part of legal disputes, tax issues or opinions issued for transaction purposes.

Generally, it may be said that the many dozens of academic studies published in the past decades reached the conclusion that using fair or current value in financial statements supports their relevancy despite the cost of applying fair value in accounting. Over the years, this trend was also clearly reflected in policies of standard-setting bodies worldwide, which increased the use of fair value in financial statements. It is important to emphasize that along the potential benefits arising from the use of fair value, the key disadvantage of such use naturally pertains to the level of subjectivity or reliability of some fair value measurements. Accounting standards currently deal with these issues in the form of disclosure requirements whereby main assumptions and the estimate’s level within the fair value hierarchy (levels 1–3) should also be disclosed in the financial statements.

The gradual transition from historical cost accounting to fair value accounting is a prominent trend in accounting in the past few decades. The impact of this transition may even permeate into the real world and have an actual impact thereon rather than just describe it. Thus, for example, one of the concerns regarding frequent use of fair value is that such use may encourage companies to sell assets at times of crisis, since they wish to avoid recognition of additional future losses that may be caused by a further future decrease in fair values. The underlying argument of this concern is that fair value supposedly has a procyclical impact since it increases supply and causes further price decline in times of crisis; another example pertains to companies’ ability to unlock value by revaluating investment property under IFRS, which is not allowed under US accounting standards—this might encourage US-based real estate companies or funds to issue their shares or units in other jurisdictions in order to be able to apply IFRS and improve their level of leveraging reflected in their financial statements compared to what it would have been under US GAAP. Another behavior that may be impacted by the use of historical cost accounting rather than fair value accounting is the potential tendency to dispose of assets (or even dispose of assets and repurchase similar assets, as in the case of wash sales of financial assets measured at amortized cost), in order to recognize the profits accrued from increase in value.

A significant advantage of fair value accounting is the fact that it is easy to understand and apply in financial statements, assuming that fair value can be reliably estimated. This advantage is particularly prominent when comparing fair value accounting to other measurement bases, such as amortized cost, the equity method, consolidation, best estimate and so forth. The consistent improvement in capabilities of machine learning systems may make the process of determining fair value shorter, more efficient and less expensive to perform; this, together with the increasing use of fair value in financial statements, will perhaps make it possible to publish financial statements more frequently. However, using such techniques may also have the adverse effect of reducing financial statements’ transparency, since it is difficult to track the method employed in determining the result under the model used, which sometimes serves as a black box.

We are very grateful to Mr. Gil Rosenstock (CPA), for his valuable professional insights. We would also like to extend our gratitude to Ms. Ella Bashan, for her instrumental linguistic editing.

We hope that readers will benefit from reading this book.

Chapter 1

BACKGROUND

1. Overview

While the rule-based US Generally Accepted Accounting Principles (US GAAP) do not widely adopt fair value as a measurement basis, this is not the case with the International Financial Reporting Standards (IFRSs). The latter currently use fair value quite extensively, both for measurement and for disclosure purposes, with one of the key differences lying in the revaluation of investment property and property, plant and equipment (PPE) allowed only under IFRS.

However, fair value as a measurement basis is a relatively new accounting concept, at least from a historical perspective. Interestingly, the Framework for the Preparation and Presentation of Financial Statements (for International Accounting Standards (IASs)), originally published in 1989, made no mention of the term. It did mention several other possible measurement bases, such as historical cost, present value, current cost and realizable value. However, the conceptual difference, if any, between the various measurement bases—other than historical cost—was not clearly explained.

Over the years, the IASs underwent significant changes, with one of the most important presumably being the growing use of fair value as a measurement basis. Fair value also sometimes doubles as an acceptable basis for disclosure. However, prior to the formulation of IFRS 13—Fair Value Measurement, other IASs offered no unified definition of this measurement basis, nor did they provide a consistent framework for its estimation. Consequently, certain IASs that made use of fair value (for several current examples, see Section 2), as well as the related practice, were not always consistent in applying the measurement principles and even in its basic definition. In addition, some of the Standards, such as IAS 39—Financial Instruments: Recognition and Measurement, which was later superseded by IFRS 9—Financial Instruments, included a relatively detailed set of guidelines regarding the measurement of fair value, while other Standards, such as IAS 41—Agriculture, only included limited guidelines.

Originally published in 2000, US GAAP Concepts Statement 7 did discuss the fair value basis of measurement, but a similar phenomenon of multiple definitions and limited guidance was also the case under US GAAP prior to the publication of Statement of Financial Accounting Standards No. 157—Fair Value Measurements in 2006 (SFAS 157). The US national accounting standard-setter, the Financial Accounting Standards Board (FASB), was the first of the two accounting standard-setters to address this problem, with the publication of SFAS 157. The aim of SFAS 157 was to increase the consistency of fair value measurement and to expand related disclosures. This Standard was later codified to become Accounting Standards Codification (ASC) Topic 820 and, after further amendments, served as the basis for the current versions of IFRS 13 and ASC 820.

Finalized in 2011, IFRS 13 and the corresponding version of ASC 820 (hereinafter—the Standards) were developed jointly by the International Accounting Standards Board (IASB) and FASB. One of the objectives of this joint effort was to unify the meaning of fair value across the world’s two leading financial accounting frameworks. Practically speaking, it can be said that while fair value is not used as often under US GAAP as under IFRS, both Standards are very similar, with few minor differences. For more information, see Section 4. The Standards share, among other things, their illustrative Examples. However, the FASB separately developed a Basis for Conclusions (explanatory notes) summarizing its considerations in formulating the current version of ASC 820. SFAS 157 had its own Background Information and Basis for Conclusions.

The purpose of the Standards was to define—in a principled manner—what fair value is, to provide a uniform framework for measuring fair value and to establish the disclosure provisions to be applied when using this measurement basis. The Standards describe how fair value should be measured wherever another IFRS (or US GAAP accounting standard) requires or allows the fair value basis to be used. In other words, they do not specify under which circumstances and to which items fair value should be applied, nor do they address the question of where to recognize changes in fair value from one period to another, as these questions are answered by the relevant Standards using the said measurement basis. The Standards establish general principles, which apply to both financial and nonfinancial items. The Standards also include specific provisions applicable to nonfinancial items alone. Generally speaking, when IFRS 13 (or SFAS 157) came into force, the specific provisions regarding fair value measurement and related disclosure included in the various other Standards were deleted or amended.

It may be said that, as opposed to other accounting measurement bases such as historical cost or value in use, one of the main characteristics of the fair value basis under both IFRS and US GAAP is that it is intended to serve as an objective, market-based measure that is nonspecific to a particular reporting entity. Fair value is defined by IFRS 13 and ASC 820 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Thus, whether or not there are observable transactions for the appraised item, the objective of measuring fair value is to estimate the potential price of the item in an ordinary (hypothetical) transaction between market participants at the measurement date, under existing market conditions. Thus, for example, the reporting entity’s intention to hold the asset (rather than sell it) is irrelevant to the measurement. It is also important to note that, at times, estimating the fair value of specific items (such as the fair value of investments in start-up companies) may require considerable judgment and may also be subject to significant uncertainty and a relatively wide range of possibilities.

The following sections of this handbook provide a thorough explanation of the definition, principles and accounting issues associated with fair value measurement and disclosure in accounting in US GAAP and IFRS.

2. Use of Fair Value in IFRSs Compared to US GAAP

The IFRSs make extensive use of the fair value basis compared to US GAAP. In many cases, the use of this basis is mandatory, and in others, its use is an accounting policy choice. At times, it is only required to disclose the fair value in the notes to the financial statements.

Following are some examples of the use of fair value in IFRSs:

Example A—Financial Instruments

Historically speaking, fair value has mainly been used to measure financial instruments, for which, consequently, there were detailed measurement guidelines. Under IFRS, the Standards that deal with financial instruments—IAS 32—Financial Instruments: Presentation, IFRS 9—Financial Instruments, and IFRS 7—Financial Instruments: Disclosures—use fair value extensively for measurement and disclosure purposes. The same holds true for ASC Topic 825—Financial Instruments and Topic 815—Derivatives and Hedging.

Following are several key examples of how fair value is used to measure financial instruments under both systems:

a. Measurement at initial recognition: The guiding principle in IFRS 9 is that assets and liabilities should be measured at fair value at initial recognition. As a side note, the said Standard includes various restrictions that apply to situations where the transaction price at initial recognition is different from the fair value (a minimum reliability threshold approach of sorts where only Level 1 or Level 2 valuations are accepted with regard to immediate revaluations). In addition, in certain classes of financial instruments, at initial recognition, the transaction costs incurred by the reporting entity should be added to the fair value upon the instrument’s origination or purchase. Under US GAAP, derivatives are generally measured at fair value at initial recognition, with any difference between the transaction price and the fair value recognized immediately without any minimum reliability threshold.

b. Subsequent measurement: Pursuant to IFRS 9, a reporting entity is required (and sometimes entitled) to measure financial assets or financial liabilities at fair value through profit or loss and financial assets only at fair value through other comprehensive income. A similar logic exists under US GAAP ASC Topics 825 and 815, which includes a so-called fair value option.

c. Fair value disclosure of financial assets and financial liabilities: As a rule, according to IFRS 7, the notes to the financial statements should include a disclosure of the fair value of financial assets and financial liabilities as at the reporting date, especially if the instruments are not measured at fair value in the statement of financial position. A similar requirement exists under US GAAP ASC Topic 825.

Example B—Business Combinations

IFRS 3—Business Combinations establishes a guiding principle whereby, except for a number of specified exceptions, the acquirer in a business combination shall recognize the acquiree’s identifiable assets and liabilities and measure them at their fair value as at the acquisition date. This is also generally the case under US GAAP ASC Topic 805—Business Combinations.

Example C—Property, Plant and Equipment, Investment Property and Intangible Assets

Under IFRS, the Standards dealing with PPE, investment property and intangible assets allow the use of fair value as a relevant measurement alternative following the item’s initial recognition. Thus, IAS 16—Property, Plant & Equipment allows for each class of PPE to be measured at subsequent dates at either amortized cost or fair value (the revaluation model). However, it is noted that the said Standard permits the revaluation model to be applied only if an item’s fair value can be reliably measured. Similarly, IAS 38—Intangible Assets allows for a choice of the subsequent measurement of intangible assets for which there is an active market (as defined in IFRS 13; for more information, see Chapter 12, Section 2.2) between an accounting policy under which the assets are measured at amortized cost and one in which they are measured at fair value (the revaluation model).

IAS 40—Investment Property provides a choice between the amortized cost model and the fair value model as an accounting policy for the subsequent measurement of investment property. As a rule, under the fair value model, periodic measurement of the fair value of an asset shall be made while recognizing fair value changes in profit or loss. In addition, IAS 40 requires the fair value of investment property to be disclosed in the notes to the annual financial statements if the fair value model was not chosen.

It is important